You are on page 1of 20

Exchange

Active andTraded
passiveFunds
investing
(ETFs)
What you needindex
Understanding to know
ETFs and how they work
This guide has been produced for educational purposes only and should not be regarded as a substitute for investment
advice. Vanguard Asset Management, Limited only gives information on products and services and does not give
investmentadvice based on individual circumstances. The value of investments, and the income from them, may fall
orriseand investors may get back less than they invested.

The value of investments, and the income from them, may fall or rise and investors may get back less than
theyinvested.

2
This guide aims to give you a better understanding of Exchange Traded Funds
(ETFs), andthe increasing number of options you have when considering your
investment strategy.

This guide:

1 Provides a straightforward introduction to ETFs.

2 Explores ETFs and their role in investing.

3 Describes how ETFs work.

4 Outlines the reasons why you might choose an ETF over other types of
fundstructures.

5 Lays out what you may want to consider before investing.

This guide should help you to gain an understanding of the basics of ETFs and
how they work. It may also help you to understand how and why you might
include ETFs in your investment portfolio.

1
3 Why consider ETFs?

5 What are Exchange Traded Funds (ETFs)?

8 ETFs: another way to invest in index funds

10 ETFs in context

12 How to invest in an ETF

14 Things to think about before investing in an ETF

16 What next?

2
Why consider ETFs?

There are a number of Diversification Targeted investing


reasons why you might
Like other index funds, an index ETF Some ETFs track indices in specific
consider an ETF including offers broad diversification across market segments, such as large US
flexibility, transparency a market or sector by holding all or companies or specialist types of
orcost. most securities in the index. Holding bonds,for example. This can be an
abroad base of assets helps ensure important tool that you can use when
that an investor is exposed to the best- constructing a portfolio to meet your
performing market segments, which investment objectives.
also helps to offset weakness inothers.

3
Flexibility Transparency Potentially lower
annualcosts
ETFs can be bought and sold quickly If you select a straightforward index
and easily. As a result, you can use ETF, its a very transparent investment Many ETFs have lower annual costs
them to restructure your portfolio because it simply holds most or all of than traditional index funds. This
swiftly following a change in your the stocks in an index and the holdings can have a significant impact on the
lifecircumstances or goals. are disclosed daily. That way you can investment returns your portfolio earns
truly understand the market risks that over the long term. However, ETFs
you are exposed to. have some up-front trading costs that
traditional index funds dont, which are
explained later in this guide. Youwill
need to carefully consider the full
cost of investing to make sure youre
getting the best deal possible for your
particular circumstances.

4
What are Exchange Traded Funds (ETFs)?

The number of ETFs available Another type of pooled Most index ETFs track their
to UK investors is growing investment fund respective indicesby investing in all,
or arepresentative sample, of the
rapidly and they can be a ETFs are usually nothing more than companies included in the underlying
useful tool for constructing another type of pooled investment index. Some, however, use specialist
broadly diversified long-term fund. They differ from other pooled financial instruments to track the
funds in that shares in an ETF trade on index. Before investing in an index
portfolios, as long as you
a stock exchange like listed company fund, you need to appreciate how
clearly understand what they shares, rather than through an thefund tracks the index and all the
are and how they work. investment manager. The most popular risks involved.
ETFs simply track major indices, such
as the FTSE All-Share Index in the UK
or the S&P 500 Index in the US.

5
Because ETFs are easily tradeable
and sometimes offer cheaper annual What is an index?
charges than other types of pooled An index is a collection of shares
funds, they are attractive to many or bonds chosen to represent
types of investors. This guide covers a particular part of the market.
several important factors you should Index investors use indices
consider before investing in ETFs. to track market performance.
A change in the return of an
index should produce an almost
identical change in the price of a
fund that tracks it.

6
Some key terms Index or passive management Portfolio A combination of
Aninvestment approach aiming to investments. A portfolio is frequently
Active management An investment closely match the returns of an index created to meet particular investment
management approach where the or other benchmark. objectives, such as providing capital
manager selects securities from the growth or regular income.
investment universe prescribed by Mutual or pooled investment fund
a funds investment objective. The Aninvestment vehicle where a number Stockbroker An agent dealing in the
goal of an actively managed fund is of individual investors pool their stock market on behalf of individuals
to beat, rather than simply match, the money to create a large, professionally or institutions. Some offer investment
return from a particular market index managed fund. advice, others simply execute
orbenchmark. trades. There are also online low-fee
Net asset value (NAV) The value of stockbrokerage services.
Diversification A strategy for afunds assets less its liabilities.
protecting against risk by spreading Stockmarket Secondary markets,
a portfolio across different types Open-ended fund A pooled such as the London Stock Exchange,
ofinvestments. investment scheme where the number where previously issued securities
of units in thefund varies according arebought andsold.
Index A portfolio of securities to the number ofinvestors buying and
assembled with the goal of closely selling holdings in the fund.
matching a market or economy.

7
ETFs: another way to invest in index funds

Most, but not all, ETFs use UK.Thats why passive investments Please see the guide in this series
are often called index funds or called Active and passive investing:
index strategies, which
tracker funds. They have a simple, What you need to know, for a
means they usually track a precise objective: to seek to match more detailed understanding of the
major equity or bond index. the performance of a specific index, nature of index management. The
ratherthan to try to beat it. guideisavailable free on our website.

What is index management? Passive managers do this by buying


and holding all or a representative Another type of pooled fund.
Index (also known as passive) sample of the securities in the index.
managers generally believe it is difficult The advantage of this approach is that ETFs simply provide a way to access
to out-think the market, so they try to it spreads risk widely within a market, thereturn of a market index, in the
match the performance of the market avoiding the losses that can follow a same way as any other type of pooled
(or their chosensector) as a whole. dramatic decline in any one specific or mutual fund that tracks an index.
company or industry sector. However, But there are somedifferences.
They tend to do this by closely risk is spread rather than avoided.
following or tracking an investment The passive approach cannot protect With a pooled fund, investors combine
index, such as the FTSE All-Share against broad market declines. If the their money in a fund, which then
Index, which tracks the combined index goes down, the index fund will invests in a range of securities. Each
performance of nearly all the go down by the same degree. investor shares proportionally in the
stockmarket shares traded in the funds investment returns including
8
any income. Every pooled fund has The annual charges are, on average, Most ETFs disclose the securities in
a manager who invests according to cheaper for ETFs because they are theunderlying portfolios daily, which
the funds objective. Depending on slightly cheaper to run. But because means investors always know what
this objective, a fund may invest in they are bought and sold through theETF holds.
equities, bonds, property, cash or a a stockbroker, there are some
combination of these assets. trading costs, such as stockbroker
commission, that can offset this Individual Savings Accounts
ETFs are a type of pooled fund. saving, which you need to take (ISAs)
Buying shares in an ETF is done intoaccount. These are tax efficient savings
through a stockbroker or an online or investment vehicles that allow
platform, rather than directly with Most ETFs hold all (or a you to save and invest a limited
the fund management company. representative sample) of the amount, each year. There are two
underlying securities in the target kinds of ISA: stocks and shares
The share price is continually index. Some, however, use specialist ISAs, and cash ISAs. All gains
updated by the stock exchange synthetic financial instruments to you make on funds and cash held
throughout the day, rather than track the index. No one technique within an ISA are free of tax.
provided by the fund manager is better than the other, but its
onceper day. important that you understand the
type of fund you are investing in
andthe risks involved.

9
ETFs in context

Index funds come in a online broker platform. ETFs can be Unit Trust
actively managed or indexed, although
number of different types,
the vast majority of ETFs currently A pooled fund established as a
of which ETFs are only available areindexed. trust. A unit trust is an open-ended
one. Understanding the investment. This means that the
differences can help you to manager can create or cancel units
make the right choices when OEIC (Open-Ended depending on public demand.
Investment Company)
constructing your portfolio.
A pooled investment fund similar to Investment Trust
a unittrust, but established under
Exchange Traded Funds company law,rather than trust law. A closed-ended fund (a fund
(ETFs) As such, it issues shares, rather than with alimited number of shares)
units, but these are nottraded on a established as a company, with the
A pooled investment with shares stock exchange, they are issued by aim of producing returns by investing
that trade on a stockmarket like an the OEIC itself. The OEIC increases or in other companies. Investment trusts
individual share or bond. ETF shares reduces the numbers of sharesissued trade like shares on stock exchanges
are priced and traded throughout the in response to demand frombuyers and are priced and traded throughout
business day, and they can be bought and sellers, which is why itscalled the business day. They can be bought
and sold through a stockbroker or `open ended. and sold through a stockbroker.

10
Summary of differences

ETF OEIC Unit Trust Investment Trust

Structure Open ended Open ended Open ended Closed ended

Pricing Price linked to Net Asset Single price, linked directly Bid-offer spreads apply, with Price indirectly linked to NAV
Value (NAV), but can also to NAV price directly linked to NAV and driven by market
be affected by market
movements

Trading Any time during market Once a day on unknown Once a day on unknown Anytime during market hours
hours at real-time prices future prices future prices

Access Purchased and sold on Directly with fund manager, Directly with fund manager, Purchased and sold on
stock exchanges through online platform or adviser online platform or adviser stock exchanges through
stockbrokers stockbrokers

Investment style Active or index Active or index Active or index Active (small number of
index)

ISA?* Yes Yes Yes Yes

*ISA A tax-efficient savings or investment wrapper created by the British government. You can only invest up to a set limit
in each tax year. ISA availability is based on your personal circumstances. All tax rules and arrangements referred to above are
subject to change at any time. For more information please see the HMRC website at www.hmrc.gov.uk/leaflets/isa.htm
11
How to invest in an ETF

Investing in an ETF differs ETFs trade on the Investing in an ETF


from investing in conventional stockmarket
In seeking to create a mix of
funds, which can increase ETFs are traded on a stock exchange, investments thats right for you and
their appeal in certain sothey can be bought and sold your investment objectives, you might
circumstances. However, through a stockbroker or online consider that ETFs are an appropriate
platform anytime the market is open. part of your portfolio.
it also means there are a
Like all investment funds, ETFs entail
number of things you need the same risks and potential rewards Once you have done your research and
to consider carefully before of the markets. The valueof ETF identified a suitable product, you can
investing. shares will rise and fall with the wider place an order to buy ETF shares with
stockmarkets, so an ETF can gain or a stockbroker or online platform with
losevalue over short or long periods. a stockbroker link. The broker will then
initiatethe trade in the stockmarket.
Astock exchange, such as the London
Stock Exchange, will complete the trade
with the stockbroker on your behalf.
When the transaction is complete,
the ownership of the ETF shares will
transfer to you.

12
Investing in an ETF
Stockbroker
ETFs are bought and sold through a stockbroker or online broker/platform. An agent dealing in the
stockmarket on behalf of
individuals or institutions.
Sometimes they offer investment
advice, other times they simply
Invest Buy ETF execute the trades their client
Stockmarket wants. There are also online low-
Investor Stockbroker
fee stockbrokerage services.
Divest Sell ETF

13
Things to think about before investing in an ETF

You need to consider a Key points to consider Your investment objective


number of factors before and riskprofile
Your decision about whether to invest
selecting an ETF. This inETFs is likely to be based on the One of the first things you will do
sectionoutlines some following factors: istounderstand your investment
ofthemost important. Your investment objective objective(s), investment time horizon
Your full risk profile and risk profile. This should form the
Investment time horizon basis of any decisions you make. You
Transaction amounts can use the series of educational
Costs, including trading costs guides available free on our website
andannualcharges. atvanguard.co.uk to help you
understand thisprocess.

14
ETF costs in context Transaction amounts Time horizon

Unlike other types of mutual funds Some stockbrokers or online broker Even though ETFs generally have
(except Investment Trusts), ETFs trade platforms charge a flat fee for each lower annual charges, the trading
through a stockbroker with stockbroker trade, whether buying or selling. You costs of dealing in stockmarket shares
charges and other trading costs should consider how high this fee is can make the initial investment costs
involved when you invest. These costs relative to the amount that you are more expensive than a traditional
will affect the decision you make about likely to invest in an ETF. If the trade index mutual fund. It might take some
when and how to use ETFs in your is relatively small, it might not make time for the cheaper annual charges
investmentportfolio. sense to use an ETF, but with larger toresult in a lower cost of investing
trades, it might. for an ETF vs. a traditional index
mutual fund.

Regular savings There is a break-even point at


whichthe costs of investing in
Again, because of stockbroker charges ETFsand mutual funds are equal.
on buying and selling ETFs, it might Weighing this point against your
not make sense to use ETFs for likely holding time will be a key
regular investing. Consider whether consideration in selecting the most
those charges are likely to offset the appropriate investment vehicle.
generally lower annual charges of ETFs.
15
What next?

This guide has explored You should now have a better Visit our website at vanguard.co.uk
understanding of when and why toaccess the entire suite of investment
howETFs work and what
you mightconsider an ETF for your education materials that we have
youneed to know about portfolio andhow they might help you produced to help you gain a deeper
before selecting an ETF as to help you meet your financial goals. understanding ofinvestments.
part of a broadly diversified
investment portfolio.

16
17
Connect with Vanguard
Vanguard.co.uk

Important information
This guide is designed only for use by, and is directed only at persons resident in the UK. The information on this document does not constitute legal, tax, or investment advice. You must not, therefore, rely
on the content of this document when making any investment decisions. The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell
securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation
isnot qualified to do so.
ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.
London Stock Exchange Group companies include FTSE International Limited (FTSE), Frank Russell Company (Russell), MTS Next Limited (MTS), and FTSE TMX Global Debt Capital Markets Inc.
(FTSETMX). All rights reserved. FTSE, Russell, MTS, FTSE TMX and FTSE Russell and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the
London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under licence. All information is provided for information purposes only. No responsibility or liability can
be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication. Neither the London Stock Exchange Group companies nor any of
its licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE All-Share Index or the fitness or
suitabilityof the FTSE All-Share Index for any particular purpose to which it might be put.
The S&P 500 Index is a product of S&P Dow Jones Indices LLC (SPDJI), and has been licensed for use by Vanguard. Standard & Poors and S&P are registered trademarks of Standard & Poors Financial
Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); S&P and S&P 500 are trademarks of S&P; and these trademarks have been licensed
for use by SPDJI and sublicensed for certain purposes by Vanguard. Vanguards [Product(s)] is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, or their respective affiliates and none
ofsuch parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
2015 Vanguard Asset Management, Limited. All rights reserved. VAM-2015-08-13-2797